Cash flow statements: the direct or indirect method?

In common with each other, accounting standards on the statement of cash flows issued by four major standard-setters all require the reporting of the cash flow from operations figures. Two methods are available: the direct method, whereby categories of cash receipts and cash payments are reported, or the indirect method, whereby profit or loss from operations is adjusted for, among other items, non-cash transactions and changes in working capital.

However, a comparison of whether accounting standards require this figure to be derived by the use of the direct or indirect method reveals differing approaches, with IAS 7 Statement of Cash Flows – the international standard for the private sector – an outlier. Is it time for the International Accounting Standards Board (IASB) to reconsider its approach?

In response to feedback on its Third Agenda Consultation, the IASB announced in September 2024 the start of a comprehensive review of its standard on the statement of cash flows. Seeking to influence the IASB in its early deliberations, the UK Enforcement Board has launched a number of research projects to develop its own thinking on desirable reforms in the cash-flow standard. So, how does the IASB compare against other major standard-setters across the private and public sector?

The private sector

In its 1987 standard, Statement of Financial Accounting Standards No 95 Statement of Cash Flows, US standard-setter the Financial Accounting Standards Board (FASB), allowed the use of either the direct or indirect method but “encouraged” the use of the former. FASB required that enterprises using the direct method “shall determine and report the same amount for net cash flow from operating activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities (the indirect or reconciliation method)”. These requirements became effective in 1988 and, while the standard now has the title of ASC 230, remain effective today.

In 1992, the international standard-setter – the International Accounting Standards Committee (IASC) as it was then – issued IAS 7 Cash Flow Statements. IAS 7 also allowed the use of either the direct or indirect method and it likewise “encouraged” use of the direct method. It did not, however, require entities using the direct method to do an indirect-type reconciliation. When the IASC transformed into the IASB in 2001, IAS 7 was adopted as constituting International Financial Reporting Standards (IFRS) and the requirements have remained in place.

Despite the encouragement to use the direct method in their respective standards, the vast majority of US companies, and apparently a majority of entities using IFRS Accounting Standards, have opted to use the indirect method in their statement of cash flows.

The public sector

Turning to the public sector, the US’s Governmental Accounting Standards Board (GASB) published its accounting standard on the topic in 1989. Effective from 1991, Statement No 9 Reporting Cash Flows of Proprietary and Nonexpendable Trust Funds and Governmental Entities that Use Proprietary Fund Accounting required proprietary funds to include a statement of cash flows as part of its full set of financial statements. Proprietary funds are those in government that engage in business-type activities and that assess a fee or other changes for the services they render.

In its summary of the standard, GASB stipulated: “Governmental enterprises are encouraged to report cash flows from operating activities directly by showing major classes of operating cash receipts and payments (the direct method), although the indirect or reconciliation method may be used. If the direct method is used, a reconciliation of operating income to net cash flow from operating activities is required to be provided.”

An extensive survey of the perceptions of the statement of cash flows by users of governmental financial reports authored by academic G Robert Smith Jr in 1995 found: “Most respondents believe that the direct method is superior to the indirect method for five SCF [statement of cash flows] reporting objectives. Additionally, most respondents indicate that the direct method with a reconciliation of operating income to cash flows from operations should be required for all cities preparing the statement of cash flows. This recommendation is contrary to the method currently used by most cities in reporting cash flows.”

The implication of the last sentence is that most governmental entities had adopted the indirect method.

With Smith’s findings having come to the GASB’s attention, the board issued Statement No 34 Basic Financial Statements – and Management’s Discussion and Analysis – for State and Local Governments, which, among many other things, required that only the direct method should henceforth be employed and, additionally, a reconciliation of operating cash flows to operating income should be included. Issued in 1999, this standard took effect in three phases from 2001 to 2003.

Explaining its thinking, and with a quote drawn from Smith’s research study, the board wrote in the basis for conclusions: “The Board found that the arguments presented in ED (Exposure Draft) comment letters on the proposal for proprietary funds to present a statement of cash flows using the direct method were consistent with those made on the same requirement proposed in the PV (Preliminary Views). Research has shown that respondents from four groups – finance directors, citizens and legislators, creditors, and auditors ‘clearly found the direct method to provide more and better information than the indirect method’.”

The International Federation of Accountants’ Public Sector Committee (now known as the International Public Sector Accounting Standards Board, IPSASB), issued Statement 2 Cash Flow Statements in 2000 (now known as IPSAS 2). Based primarily on IAS 7, it allows entities that prepare and present financial statements under the accrual basis of accounting to use either the direct or indirect method, but “encourages” the former. It diverges from IAS 7, however, in its approach to reporting of the indirect method when the direct method is used: “Entities reporting cash flows from operating activities using the direct method are also encouraged to provide a reconciliation of the surplus/deficit from ordinary activities with the net cash flow from operating activities. This reconciliation may be provided as part of the cash flow statement or in the notes to the financial statements.”

The majority of accrual-basis entities have adopted the indirect method, but the extent to which entities using the direct method provide the optional reconciliation is not known.

It is instructive to take note of how IPSAS 2 has been implemented in Australia and New Zealand, two world leaders in financial reporting. Both require the use of the direct method and provide that the reconciliation be presented.

IAS 7 – the outlier

One wonders why IAS 7 is the lone exception among the four standard-setters’ pronouncements, being alone in not requiring – or even encouraging – adopters of the direct method to report an indirect-type reconciliation. Such a reconciliation would enable readers of the financial statements to make comparisons between entities using the direct and indirect methods under other frameworks. As borne out in Smith’s survey findings, for entities using the direct method, the reconciliation would constitute useful information in itself.

Professor Stephen A Zeff FCA (Honorary), Rice University

Acknowledgements
The author is grateful to David Bean for the information regarding the implementation of IPSAS 2 in Australia and New Zealand. The author is also grateful to him for his comments on an earlier draft.